Module 1: Retirement Plan Investing

6.1 What major areas should an employer consider when evaluating the investment provisions of a DC plan? (Retirement Plans, p. 549)

(1) Fiduciary responsibilities (2) The role of employer stock (3) Administrative issues.

3.1 Describe the various forms of money market instruments. (Retirement Plans, p. 449)

(1) U.S. Treasury bills and notes. Treasury bills have maturities at issue ranging from 91 to 360 days, while Treasury notes have initial maturities ranging from one to five years. There is almost no default risk on these investments. In other words, the probability that either interest or principal payments will be skipped is nearly zero. (2) Federal agency issues. The Treasury is not the only federal agency to issue marketable obligations. Other agencies issue short-term obligations that range in maturity from one month to over ten years. These instruments typically will yield slightly more than Treasury obligations with a similar maturity. (3) Certificates of deposit. These certificates are issued by commercial banks and have a fixed maturity, generally in the range of 90 days to one year. The ability to sell a certificate of deposit prior to maturity usually depends on its denomination. The default risk for these certificates depends on the issuing bank, but it is usually quite small. (4) Commercial paper. This is typically an unsecured short-term note of a large corporation. This investment offers maturities that range up to 270 days, but the marketability is somewhat limited if an early sale is required. The default risk depends on the credit standing of the issuer, but commensurately higher yield is available. (5) Money market mutual funds. These funds invest in the money market instruments described above. As a result, investors achieve a yield almost as high as that paid by the direct investments themselves and, at the same time, benefit from the diversification of any default risk over a much larger pool of investments.

5.3 What factors have contributed to the shift toward enhanced investment opportunities in DC plans? (Retirement Plans, p. 549)

(a) A growing public awareness of the role of DC plans in providing economic security and of the importance of saving and investing wisely (b) An increased recognition on the part of employers of the need to provide flexibility of choice and investment education (c) Improved and more efficient admin capabilities (d) The aggressive marketing efforts of the leading mutual funds.

3.3 Describe the basic types of common stocks. (Retirement Plans, p. 451)

(a) Blue-chip stocks. These are stocks issued by major companies with long and unbroken records of earnings and dividend payments. They appeal to pension plans seeking safety/stability. (b) Growth stocks. These are stocks issued by companies whose sales, earnings and share of the market are expanding faster than either the general economy or the industry average. They represent a higher risk, but the prospects for capital appreciation should produce a correspondingly higher total return. Because they pay relatively small dividends, they may not be attractive to pension plans with cash flow needs. (c) Income stocks. These are stocks that pay higher-than-average dividend returns. They have been attractive to pension plans that bought stock for current income. (d) Cyclical stocks. These are stocks issued by companies whose earnings fluctuate with the business cycle and are accentuated by it. (e) Defensive stocks. These are stocks issued by recession-resistant companies. These may be an important consideration for pension plans that cannot afford major capital losses. (f) Interest-sensitive stocks. These are stocks whose prices tend to drop when interest rates rise, and vice versa. These are stocks issued by companies whose earnings fluctuate with the business cycle and are accentuated by it.

6.3 What are the potential disadvantages of using employer stock as an investment option within a DC plan? (Retirement Plans, p. 552)

(a) Employer stock is a completely undiversified investment option and may be inappropriate from a financial perspective. (b) Employer contributions invested in company stock at the employer's direction are not eligible for the Section 404(c) safe harbor provisions. (c) Plan sponsors that permit employee contributions to be invested in company stock must comply with SEC registration and reporting requirements. (d) Employee relations problems may surface if the value of the employer stock declines. (e) If significant balances are built up in the company stock fund, employees have not only their livelihood but also a sizable block of their savings tied to the wellbeing of the company. (f) Any investment in employer stock must be shown to satisfy the requirement that plan assets be "expended for the exclusive benefit of employees" and must satisfy the fiduciary requirement for prudence. (g) If employer stock is offered as one of the investment options, the employer must adhere to the PPA diversification requirements. The PPA rules do not apply to employee stock ownership plans (ESOPs).

5.2 Describe the benefits of a successful investment program for (a) the employer and (b) the employees. (Retirement Plans, p. 548)

(a) For the employer, the benefits of a successful investment program include: • Low-cost fees • Ease of administration • Flexibility to make needed changes in investment arrangements • Improved recognition of the company as a source of valuable benefits. (b) For employees, a well-executed investment program maximizes capital accumulation through: • Increased participation • Improved returns • Lower costs.

6.4 Discuss administrative issues that need to be addressed in structuring the investment provisions of a DC plan. (Retirement Plans, pp. 553-555)

(a) Frequency of valuation for processing loans, distributions, withdrawals and investment changes? (b) Frequency of change for employee's to make investment choices? The Section 404(c) safe harbor provisions require that employees must be permitted to make changes at least quarterly, and more often for more volatile investment options. (c) Default provisions. Employers must provide some sort of default option in the event an employee fails to make an investment election for contributions. PPA has clarified standards for default options and exempted plan sponsors from fiduciary liability when they abide by the act's requirements. (d) Negative elections. Instead of requiring an employee to elect to participate in a DC plan, employees are deemed to have elected to defer a percentage of their eligible compensation as a plan contribution unless they affirmatively elect a different deferral amount or elect not to participate in the plan. (e) Employee communications is a critical link in the long-term success of DC plans. DOL now requires that the employer offer participants sufficient information to enable them to make an intelligent choice among the investment options available to them. PPA provides a new prohibited transaction exemption allowing qualified fiduciary advisors to provide personally developed professional investment advice to assist plan participants in managing their retirement plan investments.

2.1 What types of questions should the investment manager's guideline statement cover? (Retirement Plans, p. 443)

(a) How much risk is plan sponsor prepared to take to achieve a specific benchmark rate of return? (b) What is the time period for measurement of performance relative to objectives? (c) What is the sponsor's preference in terms of asset mix, especially as it relates to stocks? (d) What is the liability outlook for the plan, and what should the fund's investment strategy be in light of this outlook? (e) What are the sponsor's cash flow or liquidity requirements? (f) How much discretion is the manager permitted regarding foreign investment, private placements, options, financial futures, hedge funds and the like?

4.1 What type of information should be elicited in a questionnaire sent to prospective investment managers? (Retirement Plans, p. 453)

(a) Portfolio strategies and tactics (b) Ownership as well as employee compensation (c) Decision-making procedures (d) List of current clients and specific people to contact for references (e) Names of accounts lost as well as those gained in recent years (f) Historic performance of each class of assets managed (g) Explanation of exactly how the firm's performance statistics have been computed.

1.1 Describe the following types of investment risk: (a) purchasing power, (b) business, (c) interest rate, (d) market and (e) specific. (Retirement Plans, pp. 441-442)

(a) Purchasing power risk reflects the relationship between the nominal rate of return on an investment and the increase in the rate of inflation. (b) Business risk involves the prospect of the corporation issuing the security suffering a decline in earnings power that would adversely affect its ability to pay interest, principal or dividends. (c) Interest rate risk comprises the well-known inverse relationship between interest rates and (long-term) bond prices. That is to say, when interest rates increase, the value of long-term bonds falls (d) Market risk refers to a stock's reaction to a change in the market. In general, most stock prices will increase if the stock market increases appreciably and decrease if the market decreases appreciably; however, the price of one stock may change half as fast as the market, on average, while another may change twice as fast. This relationship is quantified by a measure known as beta. (e) Specific risk is risk that is intrinsic to a particular firm.

2.3 Before any performance is measured, agreement must exist on the correct definition for the return that is being measured. (a) Explain the value and shortcoming of the internal rate of return definition, and (b) describe how the time-weighted rate of return is computed. (Retirement Plans, pp. 444-445)

(a) The internal rate of return is valuable in that it allows the sponsor to determine whether the investment is achieving the rate of return assumed for actuarial calculations; however, it is largely ineffective as a means of evaluating investment managers because it is contaminated by the effects of the timing of investments and withdrawals—a factor over which the investment manager presumably has no control. (b) The time-weighted value is computed by dividing the time interval under study into subintervals whose boundaries are the dates of cash flows into and out of the fund and by computing the internal rate of return for each subinterval. The time-weighted rate of return is the (geometric) average for the rates for these subintervals, with each rate having a weight proportional to the length of time in its corresponding subinterval.

2.4 The capital asset pricing model (CAPM) uses standard statistical techniques (simple linear regression) to analyze the relationship between the periodic returns of the portfolio and those of the market (for example, the Standard & Poor's 500). Explain the importance of the (a) alpha value and (b) beta value produced by the capital asset pricing model. (Retirement Plans, pp. 446-447)

(a) The portfolio's alpha value can be thought of as the amount of return produced by the portfolio, on average, independent of the return of the market. Generally alpha is viewed as the level of return contributed because of the skill of the investment manager that is managing the portfolio. (b) The beta value is the slope of the line measured as the change in vertical movement per unit of change in the horizontal movement. This represents the average return on the portfolio per 1% return on the market. For example, if the portfolio's beta is 1.25, then a 2% increase (or decrease) in the market would be expected to be associated with a 2.5% (1.25 X 2) increase (or decrease) in the portfolio, on average

Describe (a) why the tax aspect of an investment is important for a pension fund and (b) why an investment's relative liquidity may be important to a pension plan's investment manager. (Retirement Plans, p. 442)

(a) The tax aspect of an investment is important because of the tax-exempt status of the pension fund. Because investment income of qualified retirement plans is tax-exempt, certain types of investments may not be as attractive to pension funds as they would be for other types of investors. (b) Liquidity refers to the ability to convert an investment into cash in a short time period with little, if any, loss in principal. This may be an important attribute for at least a portion of the pension plan assets in case the plan has to sustain a short period of time when the plan sponsor is unable to make contributions (or contributions are less than the amount of the benefit payments for the year) and, at the same time, the securities markets are depressed. If the plan does not possess an adequate degree of liquidity, the sponsor might have to sell securities at an inopportune time, perhaps resulting in the realization of capital losses.

2.3 Before any performance is measured, agreement must exist on the correct definition for the return that is being measured. Name and describe the two alternative definitions used in investment community. (Retirement Plans, pp. 444-445)

1) internal rate of return 2)time-weighted rate of return

2.2 Describe (a) the four steps involved in effective performance measurement in (Retirement Plans, p. 444)

1)Definition: Establishment of investment objectives and, to the extent practical, a clearly formulated portfolio strategy 2)Input: Availability of reliable and timely data. Incorrect and tardy data will render the most sophisticated system ineffective. 3)Processing: Use of appropriate statistical methods to produce relevant measurements. The complex interaction of objectives, strategies and managers' tactics cannot be understood if inappropriate statistical methods are used. A meaningful summary will make possible analysis of the investment process at the necessary depth. 4)Output: Analysis of the process and results presented in a useful format. Presentation should relate realized performance to objectives and preestablished standards. Enough material should be available to understand and analyze the process. Exhibits should be designed to highlight weaknesses in the investment process and to suggest possible improvements.

2.2 Describe (b) the four important caveats that must be kept in mind in choosing a performance measurement system. (Retirement Plans, p. 444)

1)There is a danger that a hastily chosen system, poorly related to real needs, can rapidly degenerate into a mechanistic, pointless exercise. 2) The system should fit the investment objectives—not the reverse. 3) Measuring the process may alter it. 4)To save time and cost, it is important that overmeasurement be avoided.

5.4 Does a variety of investment choices in a well-structured DC plan ensure maximum benefits for participants? Explain. (p. 549)

A variety of investment choices in a well-structured DC plan does not in and of itself ensure that employees will utilize the plan to its full potential. Many plans with ample investment choices underscore the need for educating employees to become better investors. Overall, billions of dollars in DC plan assets are still being invested very conservatively and with little diversification. While this reflects the fact that employees need to know more about investments and financial planning, it also reflects the fact that many employers still have not focused on managing their plans as effectively as possible.

4.4 Describe the basic objectives behind the use of dedication and immunization techniques for pension plan portfolios. (Retirement Plans, p. 455)

Another form of passive investment of pension plan assets makes use of the bond market and has been variously referred to as dedication, immunization and contingent immunization. This technique attempts to construct a bond portfolio such that its cash flow can be used to fund specific plan liabilities, such as to pay benefits to a group of retirees.

5.1 Describe the respective roles of employers and employees in the plan investment provisions of a (DC) plan. (Retirement Plans, pp. 547-548)

Both employers and employees have a vital stake in the plan investment provisions of a DC plan. The employer is responsible for: (a) Structuring appropriate investment programs (b) Selecting suitable investment managers (c) Monitoring investment performance (d) Communicating critical investment provisions to employees. In the typical plan, employees are responsible for deciding how to invest their account balances. It is important to note that employees assume all of the risks associated with investment performance. Both employers and employees must have a sound understanding of basic investment principles if they are to succeed in fulfilling their respective responsibilities.

6.2 Does conformity with the Section 404(c) safe harbor provisions relieve an employer of fiduciary responsibility for plan investments? (Retirement Plans, pp. 550-551)

Compliance with the Section 404(c) safe harbor provisions does not relieve the employer of the responsibility of ensuring that the investment options offered under the plan are prudent and properly diversified and does not relieve the employer of fiduciary responsibility for investments over which the employee has no control, such as employer contributions that are automatically directed to one of the investment options. PPA allows (does not mandate) plan sponsors to offer investment advice services. If plan sponsors do offer such services to their participants, they assume certain fiduciary responsibilities. They must prudently select the advice provider and must monitor the services provided. Therefore, fiduciary responsibilities relate both to the appointment of the investment advice provider and the ongoing monitoring process of the investment advice provider. The Department of Labor (DOL) has specified the criteria that should be followed when appointing an investment advice provider and prescribed plan sponsors' responsibilities for monitoring the advice provided.

6.5 Describe the decisions an employer must make in the design phase of developing plan investment provisions. (Retirement Plans, pp. 555-558)

Consider what asset classes will be offered. This decision will be influenced by administrative costs, risk-and-return characteristics, plan objectives and participant needs. whether to offer asset classes as distinct investment options, from which employees will choose their own mix, or to combine them into predetermined sets of diversified portfolios reflecting different risk-and-return characteristics. Each asset class in and of itself also can be diversified, combining different management styles such as growth and value in an equity portfolio, long-term and short-term fixed income strategies, and a stable of guaranteed investment contract (GIC) providers in a GIC portfolio. (GICs are investment options for employees under certain kinds of qualified retirement plans provided under a contract with a life insurance company. The insurer guarantees the principal and interest of the GIC for the specified period of time. Employees should remember, however, that the security behind a GIC is the financial soundness of the insurance company providing it. Lifecycle funds have become more popular investment options that employers have added to the mix of asset classes. Once the asset classes or portfolios to be offered have been determined, appropriate investment objectives for each asset class must be established. Within each asset class, the employer must also decide whether to pursue an active or passive investment style. Investment managers must be selected and their performance monitored as well.

3.4 Explain the reasons pension plans often choose mutual funds as investment vehicles. (Retirement Plans, p. 451)

For plans with assets too small to be handled by an investment manager, mutual funds may be the only choice other than a common trust fund. Larger plans also may choose mutual funds as a relatively inexpensive way of diversifying their portfolios. Pension plans choose to invest in mutual funds for the following reasons: (a) Greater liquidity through ease of entry and exit (b) Greater degree of diversification (c) Easier means of portfolio specialization (d) Daily update of holdings through Internet listings (e) Ease of meeting asset allocation or market timing goals (f) Ease of checking past performance through published studies and indexes.

5.5 How has the Pension Protection Act of 2006 (PPA) provided protection to, and advanced efforts to improve investment outcomes of, DC plan participants? (Retirement Plans, p. 549)

PPA has provided protection to, and advanced efforts to improve investment outcomes of, DC plan participants through provisions that facilitate a plan sponsor's ability to provide investment advice, require investment diversification for DC plans and permit fiduciary exemption associated with automatic plan enrollment.

4.2 A passive investment strategy is characterized by a broadly diversified buy-and hold portfolio aimed at replicating the return on some broad market index at minimum cost. Explain why a passive investment strategy may be attractive to a pension plan sponsor. (Retirement Plans, pp. 454-455)

Proponents of the passive strategy argue that as the stock market becomes increasingly efficient, it is more difficult for investment managers to consistently outperform the market. If actively managed funds do indeed encounter difficulties producing a gross rate of return superior to that of the market, it will obviously be even more difficult to produce a superior return on a net basis (after the effects of fees and transaction costs have been accounted for).

1.3 What have historical studies demonstrated with respect to the risk-and-return characteristics of the major classes of investments? (Retirement Plans, pp. 442-443)

Published in 2016, an 89-year time series analysis of the major classes of investments found, as expected, that the riskiest investments also generated the highest yields. Common stocks provided the highest annual return, with small company stocks having a compound annual growth rate of 12.0% and large company stocks having a compound annual growth rate of 10.0%. However, investors purchasing common stocks paid a price in terms of the volatility of their investment. Over the past several decades, the large company stocks experienced one-year losses as high as 37.0% (in 2008). Long-term bonds issued by the government had a significantly lower return (6.0%). U.S. Treasury bills were obviously the safest investment in terms of annual volatility; however, they only generated a return of 3.4%. These figures cannot be viewed in isolation, and it is important to consider how they fared after the effects of inflation had been removed. During this period, the compound inflation rate was 2.9%, an amount that should be subtracted from the nominal rate of return to find the real rate of return produced by an investment.

2.5 How is the risk-adjusted rate of return utilized in portfolio measurement? (Retirement Plans, p. 447)

The risk-adjusted rate of return can be used to measure risk-adjusted performance and to compare portfolios with different risk levels developed by actual portfolio decisions.

3.2 Why are bonds used in pension plan portfolios? (Retirement Plans, p. 450)

The use of bonds in pension plan portfolios typically can be attributed to one of two reasons. First, if the sponsor realizes that (to a large extent) the pension plan's obligations are fixed dollar obligations that will be paid out several years in the future, there may be a desire to purchase assets that will generate a cash flow similar to the benefit payments. Second, the investment manager may be willing to purchase assets with a longer maturity than the money market instruments described above. This assumption of interest rate risk is presumably compensated for by a higher yield than that available from shorter maturities.

4.3 Explain why some sponsors will use index funds as an investment for the core of their portfolio and allow active management of the remaining amount of the assets. (Retirement Plans, p. 455)

This tactic possesses the advantage of freeing the investment managers from having to deal with the core portfolio and, instead, allowing them to focus their time on their specialty areas. Moreover, given a relative sense of security for the core investment, investment managers are able to pursue a higher risk strategy on their subset of the plan's assets in hopes of above-average returns.